If banks behaved as monetary theory says they do, negative interest rates would be a perfectly reasonable idea. The prospect of paying for the privilege of parking funds with the central bank would spur lending-shy banks into action. Credit would flow and GDP would grow. But such thinking fails the reality test.
Paul Tucker, deputy governor of the Bank of England, offered negative rates as a possible but “extraordinary thing to do” in his testimony to the UK parliament’s Treasury Committee on Tuesday. The caution reflects reality rather than theory.
Banks should already be rushing to lend. The policy interest rate of 0.5 percent is well below the inflation rate, so they are being paid, in real terms, to borrow from the central bank, and already paying, in real terms, when they collect the same 0.5 percent interest rate on deposits there. But lending remains slow in the UK, as in all other developed economies.
The theory explains this apparent irrationality as risk aversion from banks or borrowers. To counter fear, theory dictates that central bankers should make money even cheaper and more readily available – quantitative easing amounts to providing free funds – and making caution even more expensive by charging banks for doing nothing.
It’s hard to disprove, because risk aversion can always be called upon to explain apparent failures. But in practice, monetary shoves have been shown to be less powerful than whatever other forces are holding back economic activity. Interest rates have been close to or below zero for most of the last decade, without any clear positive effect on output.
The alarmed headlines that followed Tucker’s testimony help explain the policy failure. Consumers, businesses and banks feel disoriented in a financial world with confusing monetary signs. The response to a monetary push is not to run in the desired direction, but to stand still in fear. Critics of aggressive monetary policy liken the effort to use money to change minds to pushing on a string. Negative interest rates are likely to tie the economy in knots.